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From inflation to decarbonization, several global themes are strengthening the case for exposure to utilities and user-pay assets

"OUR OUTLOOK is that we will continue to see volatility, as we move toward the later parts of the cycle, and global central banks continue to take out liquidity from markets.” That’s the word from Shane Hurst, managing director and portfolio manager for the Franklin ClearBridge Sustainable Global Infrastructure Income Fund and corresponding ETF. ClearBridge Investments is one of several top-tier independent investment managers now part of Franklin Templeton. There are numerous elements contributing to volatility in 2022. Beyond the challenge of living with COVID, the world is grappling with the reverberations of the Russia-Ukraine conflict. Both disasters have contributed to multi-decade highs in inflation across countries, prompting central banks to tighten monetary policies, hopefully without triggering a recessionary scenario in the process. Given those risks, investors are weighing their options for diversifying and bolstering their portfolios. According to Hurst, exposure to infrastructure could be just what they need.

Franklin Resources, Inc. [NYSE:BEN] is a global investment management organization with subsidiaries operating as Franklin Templeton and serving clients in over 155 countries. In Canada, the company’s subsidiary is Franklin Templeton Investments Corp., which operates as Franklin Templeton Canada. Franklin Templeton’s mission is to help clients achieve better outcomes through investment management expertise, wealth management and technology solutions. Through its specialist investment managers, the company offers boutique specialization on a global scale, bringing extensive capabilities in equity, fixed income, multi-asset solutions and alternatives. With offices in more than 30 countries and approximately 1,300 investment professionals, the California-based company has 75 years of investment experience and approximately US$1.5 trillion (approximately CAN$1.9 trillion) in assets under management as of March 31, 2022.

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“By their very nature, infrastructure and utility assets are essential services. In volatile environments like we have seen recently and expect to see going forward, they're certainly a safe haven to earn a stable return and a stable dividend”

Shane Hurst, ClearBridge Investments

However, he adds, nonprofits have been resilient. “Most of our insureds are not only recovering back to their pre-pandemic state, but are in fact expanding,” he says. Parvathy Sree, vice president of nonprofit underwriting for AmTrust Financial Services, agrees. She says some nonprofits, such as homeless shelters and schools, adapted particularly well to the challenges. “Nonprofits with good management and decent financials were able to survive the last year and are seeing the fruits of their hard work and diligence,” Sree says, but she cautions growing organizations to be diligent with loss control and risk mitigation, emphasizing that while claim counts are down and court cases are in limbo, things could change.

“By their very nature, infrastructure and utility assets are essential services,” Hurst says. “In volatile environments like we have seen recently and expect to see going forward, they're certainly a safe haven to earn a stable return and a stable dividend.” Inflation immunity In operating its global infrastructure income strategy, the team aims to achieve stable returns, stable and growing cash flows, and dividends that grow in a low-volatility fashion. To do that, it invests in listed and liquid infrastructure companies, focusing on regulated and contracted utilities as well as user-pay assets that include airports, ports, rail, and road infrastructure. Looking at the universe of infrastructure companies the team focuses on, Hurst says the names they invest in don't have

direct exposure to commodity prices. That's particularly true for utility companies, which can pass rising energy input costs along to their end consumers because of regulation. Along with cash flows that are linked to and protected by concession agreements and contracts, that creates a defensive, high-income return profile with a clean pass-through of inflation. “For utilities, the weighted average cost of capital or asset bases increases as inflation increases. So what you see standalone is an increase in the revenue line in lockstep with rising inflation,” Hurst says. “In certain markets, utilities tend to perform well, and better than general equity markets. We have seen that [this] year to date, especially in regulated utilities significantly outperforming broader equity markets.” From a macro perspective, higher commodity prices, especially energy costs, put pressure on consumers; that raises the prospect of higher inflation and slow growth, particularly in Europe. While there’s a clear near-term risk of that happening, Hurst says the regulated utilities they invest in are built to perform well in such a stagflationary or recessionary scenario. The portfolio also benefits from energy infrastructure companies, which tend to experience an uplift in capex from strong commodity-price environments as they build more infrastructure to facilitate the movement of more hydrocarbons. “It's a significant positive for those companies leveraged to the multi-generational decarbonisation theme, as there's a massive push to roll out renewables to substitute in for a higher commodity price or hydrocarbon-type generation and usage,” Hurst says. “While there will be political noise around high energy prices, infrastructure and utilities are really crucial to the solution going forward. So ultimately, governments will partner with them to reduce the impact on the ultimate consumer.”

“The [claims] that are more infrequent but create the most challenge to resolve are of course sexual abuse,” Davis says. “We were one of the first carriers to offer an affirmative sexual abuse policy back in the late ’80s – so we actually said, ‘This is what we will cover’ and didn’t go silent on it.” In the face of market upheaval, insurers are promoting their offerings or planning new products. At AmTrust, Sree says, the focus has been on “cross-selling to provide more broad-based coverage and providing enhanced coverage for our insureds.” Meanwhile, Convelo is developing a few new tech-driven programs, which will be available over the next six months or so. Smith says the company is “highly focused on technology to deliver top-of-the-market products to our broker partners in an efficient, easy-to-use platform. We are using this technology not only to automate systems and make the buying process easier, but also to improve in risk selection and lower claims costs.” NIA has responded to the pandemic by rolling out a new communicable disease form on the liability side. “That’s something that really nobody else has done,” Davis says. “But we saw that we have nonprofits who have to continue housing the homeless; they have to continue to work.” The coverage form delivers $250,000 of defense inside the limits. “It’s trying to be the coverage that nonprofits need without offering limits that might become opportunistic with some plaintiff attorneys,” Davis says.

“Our renewables continue to perform outstandingly in general, as they benefit from the continued acceleration toward net-zero that needs to take place all around the world. Clearly, infrastructure utilities are at the forefront of that investment”

Shane Hurst, ClearBridge Investments

Looking at the other major prong of the Franklin ClearBridge infrastructure income strategy, Hurst says transport infrastructure companies tend to hold GDP-sensitive assets, with tolls and tariffs tracking inflation through mechanisms included in concession contracts. However, they also tend to have long-term concession contracts that are leveraged to the growth of economies around the world – which means they could face challenges from more hawkish central bank policies, and are also more likely to underperform in higher energy price environments. “We do believe we're moving toward the end of the cycle, and toward recessionary outcomes, certainly in places like Europe,” Hurst says. “In that type of outcome, utilities and defensive contracted assets do tend to perform strongly.” Thematic tailwinds The case for infrastructure investment isn’t all about defense. Looking at the team’s portfolio, Hurst says there are a number of constructive themes that are emerging. “Over the short-to-medium term, transport infrastructure will benefit from the recovery in mobility, as we see COVID becoming more endemic and vaccines obviously reaching much higher penetration around the world,” he says. Globally, a number of the utility companies in the infrastructure income portfolio are simplifying their businesses, spinning off assets that have volatile cash flows and commodity price sensitivity to create more consistent forward cash flow. Communication infrastructure continues to see very strong demand, particularly in the US, amid the continued deployment of 5G and huge demand for data.

There’s also a trend of private infrastructure money coming into listed assets. As unlisted companies hunt for attractively priced assets and pay big premiums for them, a number of the listed companies in the team’s portfolio have benefited. Probably the most all-encompassing theme, however, is the generational move toward decarbonization. Among global regulated utilities, that’s created an imperative to deploy renewable technologies and retire coal, gas, oil, and diesel plants. Beyond that, regulated utilities are having to strengthen their networks and look for cleaner fuel sources, such as hydrogen. “Our renewables continue to perform outstandingly in general, as they benefit from the continued acceleration toward net-zero that needs to take place all around the world,” Hurst says. “Clearly, infrastructure utilities are at the forefront of that investment.”

Normal balanced portfolio

8.6%

Per Annum Return

6.4%

Standard Deviation

1.2

Sharpe Ratio

Balanced portfolio + 15% exposure to ClearBridge infrastructure strategy

9.1%

Per Annum Return

6.2%

Standard Deviation

1.3

Sharpe Ratio

Source: eVestment, 10 years to 31 December 2021. Index returns used for Global REITs: FTSE EPRA/NAREIT Global; Global Equities: MSCI ACWI-ND; Canadian Equities: S&P/TSX Composite; High Dividend Canadian Equities: S&P/TSX High Dividend Index; Fixed Income: Bloomberg Global Aggregate. Infrastructure returns use the ClearBridge Global Infrastructure Income Strategy composite and supplemental returns from eVestment. Returns in CAD for illustrative purposes only.

The decarbonization opportunity in infrastructure

Source: The International Energy Agency (IEA), Net Zero by 2050: A Road Map for the Global Energy Sector

US$36 trillion

the amount of clean energy spend needed by 2050

the amount of investment in electricity networks needed by 2050

US$16 trillion

maximum annual power spend needed per annum

US$2.5 trillion

the growth in renewables, solar, and wind needed by 2030

To fully capture the impact of ESG, Hurst says the strategy follows a three-pillar ESG process that looks at both positive and negative factors and impacts. Rather than turn to third-party vendors of ESG data, ClearBridge relies on its own internal infrastructure specialists and intellectual properties to build out its views on ESG. “That process has been evolving over the last 16 years, and it’s been proven to have added value and alpha since inception,” he says. “Because we are specialist infrastructure investors, we have the ability to really dive deep into ESG factors with companies, regulators, politicians, debt providers, and local communities. And that's a big, big advantage when we're constructing portfolios in both a sustainable and a low-volatility cash flow way.”

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell, or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions, and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region, or market. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Commissions, management fees, and expenses may all be associated with investments in ETFs. Investors should carefully consider an ETF’s investment objectives and strategies, risks, fees, and expenses before investing. The prospectus and ETF facts contain this and other information. Please read the prospectus and ETF facts carefully before investing. ETFs trade like stocks, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses, and other factors. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated.

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Thematic tailwinds The case for infrastructure investment isn’t all about defense. Looking at the team’s portfolio, Hurst says there are a number of constructive themes that are emerging. “Over the short-to-medium term, transport infrastructure will benefit from the recovery in mobility, as we see COVID becoming more endemic and vaccines obviously reaching much higher penetration around the world,” he says. Globally, a number of the utility companies in the infrastructure income portfolio are simplifying their businesses, spinning off assets that have volatile cash flows and commodity price sensitivity to create more consistent forward cash flow. Communication infrastructure continues to see very strong demand, particularly in the US, amid the continued deployment of 5G and huge demand for data. There’s also a trend of private infrastructure money coming into listed assets. As unlisted companies hunt for attractively priced assets and pay big premiums for them, a number of the listed companies in the team’s portfolio have benefited. Probably the most all-encompassing theme, however, is the generational move toward decarbonization. Among global regulated utilities, that’s created an imperative to deploy renewable technologies and retire coal, gas, oil, and diesel plants. Beyond that, regulated utilities are having to strengthen their networks and look for cleaner fuel sources, such as hydrogen.

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* Hypothetical balanced portfolio includes 35% fixed income, 40% Canadian equities, 25% global equities. Source: ClearBridge Investments